a blog from young economists at Nova SBE

Government Failure and (potential) Pareto Improvements

It is not from the benevolence of the butcher, the brewer or the baker that we expect our dinner, but from their regard to their own interest.

Following this well-known quote from Adam Smith’s The Wealth of Nations, many economists believe that leaving the market to itself is a sufficient condition to produce efficient outcomes. However, it has long been known that under imperfect competition and the existence of externalities, there will always be some room for government intervention. (Greenwald and Stiglitz, 1986)With that being said, political decisions can be immensely complex and present significant limitations. For example, while a given policy adoption (increasing the efficacy of the legal structure) may have clear costs for a narrowly defined small interest (the lawyers), it may benefit a more diffused but larger group. This happens when, as it is described by Mancur Olson’s Logic of Collective Action, the later cannot overcome the free rider problem of mobilizing their elements in an effective manner. Nevertheless, this argument fails to explain why decisions that damage no one or are able to compensate the losers – henceforth, (potential) Pareto improvements – fail to be implemented.Policy making is a dynamic practice and although it may happen that, in the first stages of a process, all groups are not harmed, they may anticipate future concerns. By definition, Governments have the means to enforce contracts in the private sphere but they frequently have the option to change their own previous ideas. In this context, the Constitution is usually perceived as a guarantee (Buchanan, 1991), making changes costly.The incapacity of governments to accomplish credible commitments in establishing long term compensations is easily understood by cartels. It should be conceivable to break them and still be able to reimburse their losses. Moreover, this could also have net positive effects for authorities with increasing consumption and, consequently, increasing tax revenues. However, making the subsidy visible undermines its political viability by making it more prone to public pressures.A further problem arises within the nature of the political game itself. Assuming that the gains of a party regarding the seats in parliament are made at the expense of the others, there is, at least in relative terms, a truly zero-sum game going on. Of course, this competition can craft an obstacle to mutually fruitful bargains. Applying Akerlof’s (1970) reasoning to the creation of future legislation, if a particular party is willing to negotiate y, the others are often skeptical about it because they think that there are no grounds for a win-win situation.Additionally, the fact that information is imperfect means that there is uncertainty about the repercussions of new policies.Nowhere is all this more problematic – and ironic – than in the subject of International Trade. Economists identified accurate opportunities for (potential) Pareto Improvements by allowing countries to explore their comparative advantages (see the classical works of Ricardo, Heckscher and Ohlin). Unfortunately, the public opinion rarely has the background and/or the time to digest difficult arguments about it and looks at this area from a zero-sum viewpoint.Main reference: Stiglitz 2003